By Benjamin Beck, CFP®
Every day people come to us with a stack of statements from wherever they’re investing, whether it’s a no-load fund, or a large wirehouse or some other wealth management firm. Their holdings invariably include a wide-ranging mix of mutual funds, ETFs (exchange traded funds), bonds, some stocks, etc. The prospective client may say something to the effect of “…my portfolio is not doing well, or not doing well enough,” and look at us expectantly for a diagnosis, or preferably a cure.
A quick look at their paperwork confirms what I have suspected: they think they are properly diversified, but they are really not. Prior to my sharing with them the benefits of our disciplined strategy and the quality of our research, I first point out that a good portion of their issue is that they own too many securities. And while it would never be my recommendation, there’s a high probability that, in the long run, they would be better off selecting one simple S&P 500 index fund on their own, rather than paying a “wealth manager” to recommend owning hundreds (maybe thousands) of different securities.
You read that correctly. The investment world loosely defines diversification as the practice of investing in a wide range of different types of assets in order to minimize the volatility of a portfolio. Consequently, most wealth managers will advise you buy into a number of different asset classes and hundreds, if not thousands of securities. And that’s exactly where the trouble begins. This unfortunately common practice actually results in a condition called diworsification, where the risk/reward trade-off in your portfolio actually turns against you, adding unnecessary risk to your long-term objectives.
You can’t have all the returns and no volatility. That’s a fact.
At our firm, the definition of diversification does not encompass reducing volatility. Volatility is the variability of a portfolio over time. We believe that you shouldn’t sacrifice your overall objectives at the expense of keeping volatility at bay. Simply said: those other wealth managers introduce other asset classes in order to pacify your emotions or else you may not be able to stomach the ups and downs of the market.
Control what you can control.
You can only limit the amount of risk that is actually diversifiable. Market risk, also called systemic risk, is risk that cannot be diversified. It’s the risk of investing in the overall market. Markets crash because of a pandemic and that shuts down markets everywhere, and most everyone is affected. That’s considered non-diversifiable risk. But let’s say you own certain companies in a particular sector that are very sensitive to changes in interest rates. You can absolutely diversify by adding securities to the portfolio from other sectors that tend not to be directly affected during such times.
More is NOT better.
The average mutual fund is comprised of over 100 securities1. Yet, the maximal effects of diversification are achieved at somewhere around 15 holdings. In other words, you can’t completely diversify out all risks, but you diversify out the upper 90% of the risk with roughly fifteen securities. Of course, you can add more securities to the portfolio. In other words, you may choose to own 50 instead of fifteen, and that does, in fact, spread out your portfolio and potentially limits volatility. Over time, though, it does not increase your return. Because now your money is diluted across 50 securities, or in the average mutual fund, across 100 securities. So, the effects of a few of those securities actually doing well are muted because you have a lot less money in each security than you would have had in a concentrated basket of fifteen.
Most wealth managers aren’t willing to have the hard conversations with their clients.
In our opinion, investors are led down the wrong road when it comes to diversification. Most wealth managers are not willing to do what we do, which is to say, “In order for you to maximize the value of your portfolio over the next twenty years, you should invest in fifteen stocks. That’s fifteen diversified stocks within a rigidly defined process, that is heavily based on research, and that has a very strict sell discipline.”
Say you’re in your 50’s today and looking to retire by 65. Traditional wealth managers may see your investment time horizon as the fifteen years you have before you retire, before they downshift your portfolio into other lower-performing asset classes. The reality is that you will live significantly longer than that, and your portfolio needs to yield well into your retirement. So your actual time horizon may not be 15 years but in fact 30 or 40 years from today. That’s a lot of time for you to remain in the market.
So, what is an investor to do?
Our advice is to remain realistic about connecting your portfolio allocations to your true investment objectives. Wall Street and traditional wealth management firms, in general, don’t do a great job on educating folks, not only about what it will take for them to reach their objectives, but how to better reward themselves with the risk they are taking over the long-term.
There’s a distinct difference between what you think you want as an investor, and what you actually need. What do you think you want is what the industry is telling you: “You need bonds, you need ‘alts,’ you need ETFs,” and so on. Whereas in fact, what you need is to be investing in individual stocks, properly diversified within a concentrated portfolio, rather than diluted in a sea of investment vehicles.
We invest in individual companies that have a very, very bright future according to some of the best research analysts in the street. And we know that tomorrow is going to be different from today. We have a very strict discipline in place so that when – not “if” – the future changes for a particular company, we have something else that we can swap into our portfolio. This is what a proper diversification strategy looks like, and it’s what we do each and every day.
Ben Beck is Managing Partner & Chief Investment Officer at Beck Bode, a deliberately different wealth management firm with a unique view on investing, business and life.